Capital Structure
Katharina Lewellen
Finance Theory II
February 18 and 19, 2003
The Key Questions of Corporate Finance
ƒ
Valuation: How do we distinguish between good
investment projects and bad ones?
ƒ
Financing: How should we finance the investment
projects we choose to undertake?
2
(Real) Investment Policy
ƒ
“Which projects should the firm undertake?”
¾
¾
¾
¾
ƒ
Open a new plant?
Increase R&D?
Scale operations up or down?
Acquire another company?
We know that real investments can create value
¾ Discounted Cash Flow (DCF) analysis
¾ Positive NPV projects add value
¾ We revisit this in the course’s “Valuation” module (Part II)
3
Financing Policy
ƒ
Real investment policies imply funding needs
¾ We have tools to forecast the funding needs to follow a given real
investment policy (from Wilson Lumber)
ƒ
But what is the best source of funds?
¾ Internal funds (i.e., Cash)?
¾ Debt (i.e., borrowing)?
¾ Equity (i.e., issuing stock)?
ƒ
Moreover, different kinds of ...
¾ Internal funds (e.g., cash reserves vs. cutting dividends)
¾ Debt (e.g., Banks vs. Bonds)
¾ Equity (e.g., VC vs. IPO)
4
Choosing an Optimal Capital Structure
ƒ
Is there an “optimal” capital structure, i.e., an optimal mix
between debt and equity?
ƒ
More generally, can you add value on the RHS of the balance
sheet, i.e., by following a good financial policy?
ƒ
If yes, does the optimal financial policy depend on the firm’s
operations (Real Investment policy), and how?
ƒ
We study this in the course’s “Financing” module (Part I).
5
Capital Structures: US Corporations 1975-2001
Book leverage
Market leverage
debt / (debt + equity) (%)
50
40
30
20
10
0
1975
1980
1985
1990
1995
2000
6
Capital structure, International 1991
Book leverage
Market leverage
Debt / (Debt+Equity) (%)
60
50
40
30
20
10
0
US
Japan
UK
Canada
France
Germany
7
Sources of Funds: US Corporations 1980-2000
int
120
debt
equity
% of total financing
100
80
60
40
20
0
-20
1980
1985
1990
1995
2000
-40
8
Sources of Funds: International 1990-94
Internal
Internal
90 120
Debt
Debt
Equity
Equity
80 100
% of total financing
70 80
60 60
50
40
30
20
10
40
20
0
79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97
-20
0 -40
US
Japan
UK
Canada
France
9
Examples: Capital structure, 1997
Industry
High leverage
Building construction
Hotels and lodging
Air transport
Primary metals
Paper
Low leverage
Drugs and chemicals
Electronics
Management services
Computers
Health services
Debt / (Debt + Equity) (%)
60.2
55.4
38.8
29.1
28.2
4.8
9.1
12.3
9.6
15.2
10
Plan of Attack
1. Modigliani-Miller Theorem:
→ Capital Structure is irrelevant
2. What’s missing from the M-M view?
→ Taxes
→ Costs of financial distress
3. “Textbook” view of optimal capital structure:
→ The choice between debt and equity
4. Apply/confront this framework to several business cases
→ Evaluate when its usefulness and its limitations
11
M-M’s “Irrelevance” Theorem
Assume
ƒ Market efficiency and no asymmetric information
ƒ No taxes
ƒ No transaction or bankruptcy costs
ƒ Hold constant the firm’s investment policies
Then
ƒ The value of the firm is independent of its capital structure
¾ Financing decisions do not matter!
12
MM Theorem: Proof 1 (pie theory)*
Equity
Equity
Debt
=
Debt
* Credit to Yogi Berra
13
MM Theorem: Proof 2 (market efficiency)
Your firm decides to raise $100 million.
ƒ
Debt financing
¾ You sell bonds worth $100 million and receive $100 million
in cash.
ƒ
Equity financing
¾ You sell stock worth $100 million and receive $100 million in
cash.
14
MM Theorem: Proof 2 (market efficiency)
ƒ
All purely financial transactions are zero NPV
investments, i.e., no arbitrage opportunity.
ƒ
Thus, they neither increase nor decrease firm value.
15
MM Theorem: Example
Current
Debt $200M
Assets $1
billion
Equity $800M
Issue new debt
Assets $1.1
billion
Old Debt $200M
New Debt $100M
Equity $800M
Issue new equity
Assets $1.1
billion
Debt $200M
Old Eq $800M
New Eq $100M
16
MM Theorem: Proof 3
ƒ
ƒ
Consider two firms with identical assets (in $M):
Asset value next year:
Firm A
Firm B
In state 1:
In state 2:
160
40
160
40
Firm A is all equity financed:
¾ Firm A’s value is V(A) = E(A)
ƒ
Firm B is financed with a mix of debt and equity:
¾ Debt with one year maturity and face value $60M
¾ Market values of debt D(B) and equity E(B)
¾ Firm B’s value is (by definition) V(B) = D(B) + E(B)
ƒ
MM says: V(A) = V(B)
17
MM Theorem: Proof 3
ƒ
ƒ
Firm A’s equity gets all cash flows
Firm B’s cash flows are split between its debt and equity with
debt being senior to equity.
Claim’s value
next year
In state 1:
In state 2:
ƒ
Firm A
(Equity)
160
40
Firm B
Debt
60
40
Equity
100
0
In all (i.e., both) states of the world, the following are equal:
¾ The payoff to Firm A’s equity
¾ The sum of payoffs to Firm B’s debt and equity
ƒ
By value additivity,
E(A) = D(B) + E(B)
18
M-M Intuition 1
ƒ
If Firm A were to adopt Firm B’s capital structure, its total value
would not be affected (and vice versa).
ƒ
This is because ultimately, its value is that of the cash flows
generated by its operating assets (e.g., plant and inventories).
ƒ
The firm’s financial policy divides up this cashflow “pie” among
different claimants (e.g., debtholders and equityholders).
ƒ
But the size (i.e., value) of the pie is independent of how the pie
is divided up.
19
Example, cont.
ƒ
In case you forgot where value additivity comes from…
ƒ
Assume for instance that market values are:
→ D(B) = $50M
→ E(B) = $50M
ƒ
MM says: V(A) = D(B)+E(B) = $100M
ƒ
ƒ
Suppose instead that E(A) = $105M.
Can you spot an arbitrage opportunity?
20
Example, cont.
ƒ
Arbitrage strategy:
¾ Buy 1/1M of Firm B’s equity for $50
¾ Buy 1/1M of Firm B’s debt for $50
¾ Sell 1/1M of Firm A’s equity for $105
Today
Firm B’s equity
Firm B’s debt
Subtotal
Firm A’s equity
Total
-$50
-$50
-$100
+$105
+$5
Next year
State 1
+$100
+$60
+$160
-$160
$0
Next year
State 2
$0
+$40
+$40
-$40
$0
D Note: Combining Firm B’s debt and equity amounts to “undoing Firm
B’s leverage” (see shaded cells).
21
M-M: Intuition 2
ƒ
Investors will not pay a premium for firms that undertake
financial transactions that they can undertake themselves (at the
same cost).
ƒ
For instance, they will not pay a premium for Firm A over Firm B
for having less debt.
ƒ
Indeed, by combining Firm B’s debt and equity in appropriate
proportions, any investor can in effect “unlever” Firm B and
reproduce the cashflow of Firm A.
22
The Curse of M-M
ƒ
M-M Theorem was initially meant for capital structure.
ƒ
But it applies to all aspects of financial policy:
¾
¾
¾
¾
¾
ƒ
capital structure is irrelevant.
long-term vs. short-term debt is irrelevant.
dividend policy is irrelevant.
risk management is irrelevant.
etc.
Indeed, the proof applies to all financial transactions
because they are all zero NPV transactions.
23
Using M-M Sensibly
ƒ
M-M is not a literal statement about the real world. It
obviously leaves important things out.
ƒ
But it gets you to ask the right question: How is this
financing move going to change the size of the pie?
ƒ
M-M exposes some fallacies such as:
¾ WACC fallacy
¾ Win-Win fallacy
¾ EPS fallacy
24
WACC Fallacy: “Debt is Better Because Debt
Is Cheaper Than Equity.”
ƒ
Because (for essentially all firms) debt is safer than equity,
investors demand a lower return for holding debt than for
holding equity. (True)
ƒ
The difference is significant: 4% vs. 13% expected return!
ƒ
So, companies should always finance themselves with debt
because they have to give away less returns to investors, i.e.,
debt is cheaper. (False)
ƒ
What is wrong with this argument?
25
WACC Fallacy (cont.)
ƒ
This reasoning ignores the “hidden” cost of debt:
¾ Raising more debt makes existing equity more risky
¾ Is it still true when default probability is zero?
ƒ
Milk analogy: Whole milk = Cream + Skimmed milk
ƒ
People often confuse the two meanings of “cheap”:
¾ Low cost
¾ Good deal
ƒ
More on this in the “Valuation” module (Part II).
26
EPS Fallacy: “Debt is Better When It Makes
EPS Go Up.”
ƒ
EPS can go up (or down) when a company increases its
leverage. (True)
ƒ
Companies should choose their financial policy to maximize
their EPS. (False)
ƒ
What is wrong with this argument?
27
EPS Fallacy (cont.)
ƒ
EBI(T) is unaffected by a change in capital structure (Recall that
we assumed no taxes for now).
ƒ
Creditors receive the safe (or the safest) part of EBIT.
ƒ
Expected EPS might increase but EPS has become riskier!
Remarks:
ƒ Also tells us to be careful when using P/E ratios, e.g. comparing
P/E ratios of companies with different capital structures.
ƒ Further confusing effect in share-repurchases: The number of
shares changes as well as expected earnings.
28
Leverage, returns, and risk
Firm is a portfolio of debt and equity
Assets
Liab & Eq
Long-Term Debt
Net
Assets
Equity
Therefore …
D
E
r
+
rE
rA =
D
A
A
and
D
E
β
+
βE
βA =
D
A
A
29
Leverage, returns, and risk
Asset risk is determined by the type of projects, not how
the projects are financed
ƒ
ƒ
Changes in leverage do not affect rA or βA
Leverage affects rE and βE
βA =
D
E
βD + βE
V
V
D
β E = β A + (β A − β D )
E
rA =
D
E
rD + rE
V
V
D
rE = rA + (rA − rD )
E
30
Leverage and beta
4
βE
Beta
3
2
βA
1
βD
-1
0
0.2
0.4
0.6
0.8
1
1.2
1.4
Debt to equity ratio
31
Leverage and required returns
0.30
rE
required return
0.25
0.20
rA
0.15
rD
0.10
0.05
0
0.2
0.4
0.6
0.8
Debt to equity ratio
1
1.2
1.4
32
Example
Your firm is all equity financed and has $1 million of assets and
10,000 shares of stock (stock price = $100). Earnings before
interest and taxes next year will be either $50,000, $125,000, or
$200,000 depending on economic conditions. These earnings are
expected to continue indefinitely. The payout ratio is 100%.
The firm is thinking about a leverage recapitalization, selling
$300,000 of debt and using the proceeds to repurchase stock. The
interest rate is 10%.
How would this transaction affect the firm’s EPS and stock price?
Ignore taxes.
33
Current: all equity
# of shares
Debt
Bad
10,000
$0
Expected
10,000
$0
Good
10,000
$0
EBIT
Interest
Net income
EPS
$50,000
0
$50,000
$5
$125,000
0
$125,000
$12.50
$200,000
0
$200,000
$20
Expected EPS = $12.5
Stock price = $100
rE = DPS / price = EPS / price = 12.5%
34
Recap: 30% debt
# of shares
Debt (r=10%)
EBIT
Interest
Net income
EPS
Bad
7,000
$300,000
Expected
7,000
$300,000
Good
7,000
$300,000
$50,000
30,000
$20,000
$2.86
$125,000
30,000
$95,000
$13.57
$200,000
30,000
$170,000
$24.29
Expected EPS = $13.57
rE = rA + D/E (rA – rD) = 0.125 + (0.30/0.70) (0.125 – 0.10) = 13.57%
Stock price = DPS / rE = EPS / rE = $100
35
Win-Win Fallacy: “Debt Is Better Because
Some Investors Prefer Debt to Equity.”
ƒ
Investors differ in their preferences and needs, and thus want
different cash flow streams. (True)
ƒ
Example: Young professionals vs. Retirees
ƒ
The sum of what all investors will pay is greater if the firm issues
different securities (e.g., debt and equity) tailored for different
clienteles of investors (Financial Marketing). (False)
ƒ
What is wrong with this argument?
36
Win-Win Fallacy (cont.)
ƒ
This reasoning assumes incomplete markets, i.e., that:
¾ There are indeed clienteles for different securities
¾ These clienteles are “unsatisfied”, i.e., that investors cannot
replicate the security at the same or even lower cost.
ƒ
A large unsatisfied clientele for corporate debt is unlikely, as
there exist close substitutes to any particular firm’s debt.
ƒ
Also, financial intermediaries are in the business of identifying
unsatisfied clientele.
ƒ
Win-Win situation is more likely for more exotic securities or
sophisticated financial arrangement
37
Practical Implications
ƒ
When evaluating a decision (e.g., the effect of a merger):
→ Separate financial (RHS) and real (LHS) parts of the move
→ MM tells that most value is created on LHS
ƒ
When evaluating an argument in favor of a financial decision:
→ Understand that it is wrong under MM assumptions
→ What departures from MM assumptions does it rely upon?
→ If none, then this is very dubious argument.
→ If some, try to assess their magnitude.
38
What’s Missing from the Simple M-M Story?
ƒ
Taxes:
→ Corporate taxes
→ Personal taxes
ƒ
Costs of Financial Distress
39
Capital Structure and Corporate Taxes
ƒ
Different financial transactions are taxed differently:
→ Interest payments are tax exempt for the firm.
→ Dividends and retained earnings are not.
→ Etc.
ƒ
Financial policy matters because it affects a firm’s tax bill.
40
Debt Tax Shield
Claim: Debt increases firm value by reducing the tax burden.
ƒ
Example: XYZ Inc. generates a safe $100M annual perpetuity.
Assume risk-free rate of 10%. Compare:
¾ 100% debt: perpetual $100M interest
¾ 100% equity: perpetual $100M dividend or capital gains
Income before tax
Corporate tax rate 35%
Income after tax
Firm value
100% Debt
Interest Income
$100M
0
$100M
100% Equity
Equity income
$100M
-$35M
$65M
$1,000M
$650M
41
Intuition
ƒ
MM still holds: The pie is unaffected by capital structure.
Size of the pie = Value of before-tax cashflows
ƒ
But the IRS gets a slice too
ƒ
Financial policy affects the size of that slice.
ƒ
Interest payments being tax deductible, the PV of the IRS’ slice
can be reduced by using debt rather than equity.
42
“Pie” Theory
Equity
Debt
Taxes
43
Example
In 2000, Microsoft had sales of $23 billion, earnings before
taxes of $14.3 billion, and net income of $9.4 billion.
Microsoft paid $4.9 billion in taxes, had a market value of
$423 billion, and had no long-term debt outstanding.
Bill Gates is thinking about a recapitalization, issuing $50
billion in long-term debt (rd = 7%) and repurchasing $50
billion in stock. How would this transaction affect Microsoft’s
after-tax cashflows and shareholder wealth?
44
Microsoft: Balance sheet in $ millions
Item
Cash
Current assets
Current liabs
LT debt
Bk equity
Mkt equity
Sales
EBIT
Taxes
Net income
Oper CF
1997
8,966
10,373
3,610
0
9,797
155,617
1998
13,927
15,889
5,730
0
15,647
267,700
1999
17,236
20,233
8,718
0
27,485
460,770
2000
23,798
30,308
9,755
0
41,368
422,640
11,358
5,314
1,860
3,454
4,689
14,484
7,117
2,627
4,490
6,880
19,747
11,891
4,106
7,785
10,003
22,956
14,275
4,854
9,421
13,961
45
Microsoft, 2000 ($ millions)
EBIT
Interest (r × 50,000)
Earnings before taxes
Taxes (34%)
After-tax earnings
Cashflow to debtholders
Cashflow to equityholders
Total cashflows to D & E
No Debt
$14,275
0
$14,275
4,854
$9,421
Debt
$14,275
3,500
$10,775
3,664
$7,111
$0
$9,421
$9,421
$3,500
$7,111
$10,611
46
Tax savings of debt
Marginal tax rate = τ
Taxes for unlevered firm………………τ EBIT
Taxes for levered firm………………... .τ (EBIT – interest)
Interest tax shield …………………..τ interest
Interest = rd D
Interest tax shield (each year) = τ rd D
Note: only interest, not principal, payments reduce taxes
47